The strong response in the markets was thanks to a Fed statement that emphasised that its approach to future tightening would be cautious, and gradual. The Fed noted that US domestic inflation was still below its two per cent target, and that there was still room for the labour market to improve. This set to rest any questions about whether a sharp series of hikes was possible in 2016, and investors were consequently relieved. The Fed also indicated that its balance sheet would stay at its current extraordinarily large size until the rate-normalisation process was properly underway. It is being seen as unlikely that any further hikes will come before March and probably not before June, and the overall schedule will depend upon a clear observable, namely US domestic inflation’s divergence from the Fed’s target. In this response, however, some important data points are being missed — such as the fact that the Fed’s committee, judging by its forecasts that were released, generally believes that there will be at least four more quarter-point rate increases by the end of next year.
Investors were also cheered by the Fed’s cautious optimism about the state of the US economy. Janet Yellen, chair of the Federal Reserve Board, viewed US domestic spending as healthy and “growing at a solid pace.” On the overall picture, she said: “The economic recovery has clearly come a long way, although it is not yet complete.” In general, investors interpreted Dr Yellen’s view of the US economy as rosy, and noted also that she did not seem to emphasise the existence of any major overseas threats to financial stability and growth recovery. She did admit to being “surprised” by oil’s continuing slide in prices, but insisted that, once oil stabilised, inflation would resume its steady rise.
The deeper point here is that the US Federal Reserve and Dr Yellen have clearly learnt from the “taper tantrum” that resulted when the Fed almost casually let slip in 2013 that its bond-buying “quantitative easing” programme would begin to be reduced in scale. Clear and coherent communication of its intentions has allowed markets to gradually price in the future. It is also worth noting that this is, in some sense, the beginning of the end of the extraordinary policies that were put into place worldwide following the 2008 financial crisis. Too many economies, including India’s, have begun to grow accustomed to those extraordinary policies, and the excess liquidity they provided. While India’ external account is stable, the government and the central bank must remain watchful.